Is the time ripe for a rate cut? Who will benefit from such a move?
Ajit Ranade
Chief Economist, ABN Amro Bank, India
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This year is unprecedented in at least four different ways for the Indian economy. These are: the lowest bank rate in 30 years; a positive current account for the first time in 24 years accompanied by a forex surge; a disinvestment momentum leading to the creation of market capitalisation of more than Rs 70,000 crore in a lacklustre stock market; and finally, a drought which may be the worst in 15 years.
Coming to the topic under discussion, it must be remembered that the bank rate at 6.5 per cent and the cash reserve ratio (CRR) at 5 per cent are at their lowest in the last 30 years.
The CRR and the statutory liquidity ratio (SLR), which require banks to invest at least 25 per cent of their deposits in government securities, have acted as a quasi-fiscal burden on the banking system -- a de facto 'tax' on financial intermediation. And this tax on banking is the lowest it has been for a long time.
In the past the, SLR used to limit profitable bank lending, but at present banks prefer to park much of their funds (36 per cent of their deposits instead of the mandatory 25 per cent) in government securities. Either there isn't credit demand forthcoming from elsewhere, or banks are being extremely risk averse, or both.
In any case, this past year, an unprecedented drop in yields on government bonds enabled banks to book record profits.
However, because of this exposure, banks have become seriously dependent on what happens in the bond market, such that a potential rise in yields would lead to significant mark-to-market losses in their books, and might possibly wipe out the capital of some banks.
The movement in yields is clearly not going to be one way. So, clearly the strategy for banks should be to grow other retail and corporate loan assets.
Will a bank rate cut by the Reserve Bank of India help? The recent growth of home loans shows that retail asset growth is responsive to rate cuts. But it is doubtful whether corporate loans, which form the bulk of bank assets, will really grow. If anything there is danger that since a rate cut will squeeze bank margins (because their cost of raising deposits cannot be lowered due to a floor on the savings deposits rate), banks may choose the ever-safer option of parking even more funds in government securities.
This will lower yields further, spurring a rally in the gilt markets and lowering the cost of borrowing for the government, but not leading to any significant growth in credit offtake.
The gains of a rate cut thus accrue only to the biggest borrower in the system -- the government-- which gobbles up more than three fourths of the financial savings of all households. The government should not be tackling deficit and debt sustainability problems only by lowering the interest costs.
Lending rates are not the main culprits thwarting credit growth. For that matter, the recent Ordinance on non-performing assets has the potential to trigger growth in lending. A focus on the small and medium enterprises segment, which is more concerned about access to credit than the price of credit, is another trigger.
A rate cut will hurt depositors, although the inflation-adjusted returns on bank deposits might not be as bad as it seems.
And real interest rates in India have to factor in a premium for the closed-ness of the capital account, inflation differentials and country risk, in order to attract foreign direct investment.
...widespread impact unlikely
Janak Desai
Country head, treasury IDBI Bank
The Reserve Bank of India (RBI) has already obliged the markets by cutting the repo rate (the rate at which it borrows overnight money from banks) by 25 basis points (from 6 per cent to 5.75 per cent) in June this year.
The government securities market has seen considerable gains with 10-year yields dipping to 7.18 per cent from a peak of 8.10 per cent in mid-April. And the market seems to be waiting for a bank rate cut now.
But would a cut meet the RBI's current objectives? On the one hand, there is excess liquidity in the banking system, a burgeoning foreign exchange kitty and low inflation.
On the other is the spectre of drought due to the inconsistent monsoon, concerns of a slowing down in the global economy, a possible interest rate easing in the United States, and faltering domestic consumer/industrial confidence levels.
So the RBI needs to address two issues. First, it needs to ensure that it does not create an asset bubble in the fixed income markets driven by excess liquidity.
Secondly, it has to ensure an enabling environment which spurs growth and global competitiveness. Over the past couple of years, the economy has reaped the benefit of a rapid reduction in interest rates engineered by the RBI. Today real interest rates would compare favourably with global interest rates if the long-term inflationary trend is used to compute real interest rates. But the RBI's generosity has not percolated down to a large section of private borrowers.
This has more to do with the structural issues in the economy rather than the absolute level of interest rates. The financial sector continues to reel under the burden of massive non-performing assets. The interest rates on government-sponsored savings programs do not completely reflect the reduction in interest rates in the economy. This has kept the banking sector from cutting interest rates at which they borrow as much as they would have liked.
A cut in the bank rate will not have any significant impact on credit availability or price such that we can successfully pump prime the economy. Yes it would surely help the largest borrower in the economy, the government.
A 100 basis point reduction in interest rates in the 10-year segment would effectively translate into an annual saving of approximately Rs 1,400 crore for 10 years for the Centre, given its current year borrowings programme.
The enormity of the contribution of this cut would be apparent when viewed in the context of the expected revenues that the government would generate on successful disinvestments of some of the public sector undertakings.
The RBI may finally relent and indeed cut the bank rate over the next couple of months. That is more likely to be driven by its desperate need to do all it has in its powers to facilitate a healthy growth in the economy.
But that is more likely to benefit the government and the top-end corporate borrowers than have a widespread impact which would ensure a healthy sustainable economic revival.